OPINION

How Charles Evans Saved the Economic Recovery

Some revolutionaries wear Guy Fawkes masks and talk about the 1 percent, and some revolutionaries wear suits and talk about policy thresholds. Chicago Fed President Charles Evans is one of the latter.

A year ago, Evans was the rare dovish dissenter at the Fed. He didn't think it was taking the unemployment half of its dual mandate seriously enough, so he proposed a new, eponymous rule for it to do better. He certainly wasn't the first Fed president to have his own ideas about monetary policy, but a funny thing happened on his way to heterodoxy--his ideas quickly became the consensus. Now, just a year later, the Fed has fully embraced the so-called Evans Rule by linking interest rates to the unemployment rate.

Ain't no revolution like a monetary policy revolution.

It's been a brave, old world for central banks the past four years. Short-term interest rates have been stuck at zero, which, outside of Japan, hasn't happened since the 1930s. It's what economists call a liquidity trap, and it means central banks can't stimulate growth like they normally do by cutting short-term interest rates. They can't cut below zero. This doesn't mean central banks are powerless, just that they have to try new things.

These new things come in two varieties: promises and purchases. Central banks can pledge to hold short-term rates at zero even after the recovery accelerates, or they can buy long-term bonds to push down long-term rates; the former is what Paul Krugman calls "credibly promising to be irresponsible" and the latter is what we call "quantitative easing." These sound like big changes from standard operating procedure, but the goal with both is the same as normal--to reduce interest rates. It's just harder to do in a liquidity trap. Central banks have to increase expected inflation to lower inflation-adjusted rates when nominal, that is headline, rates are at zero. That's the point of these promises and purchases, and that's been the point of the Fed saying it expects to keep rates at zero through mid-2015 and buying $85 billion of mortgage and Treasury bonds a month. But as much as the Fed has done, there's still much more it can do--such as making its promises more explicit--which it started to do with its latest policy move. Let's break it down into two pieces.

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THE EVANS RULE

The Fed's big announcement was that it won't raise rates before unemployment falls to 6.5 percent or inflation rises to 2.5 percent. Notice the word "before" here. The Fed won't automatically raise rates if unemployment or inflation hits one of these thresholds, but it won't do so until at least then. These are the exact thresholds Evans endorsed a few weeks ago, which are modest tweaks from hisoriginal thresholds last year of 7 percent unemployment and 3 percent inflation.

Why all the fuss? This Evans Rule doesn't seem to tell us anything the Fed wasn't already telling us. Just look at the Federal Open Market Committee's latest economic projections. The Fed doesn't think unemployment will fall below 6.5 percent until 2015--and it never thinks inflation will rise above 2 percent--which implies rates will stay at zero until then. That's exactly what they were saying before.

In truth, the Evans revolution is less a revolution itself and more a significant step on the way to the actual revolution: NGDP targeting. We'll come back to this larger point, but first let's talk about why the Evans Rule matters. Its virtue is it should make the Fed's decision-making more transparent, and that should affect people's expectations more. Contrast the Evans Rule with what the Fed told us before--say from October--about how long zero interest rates would last.

[The Fed] currently anticipates that exceptionally low levels for the federal runds rate are likely to be warranted at least through mid-2015.